The Analyst Lent Term 2015

ISSUE 10 | LENT TERM 2015

MARKETS

Europe’s Lost Decade Viability of the Eurozone

FUNDAMENTALS

Regulation and ‘Robin Hood’ Policy: The Demise of Conventional Investment Banking?

INSIDE ANALYSIS Brunei: Exploring New Avenues

CAREERS

Internship with Machlin Oracle

FOREWORD The spotlight is now on the European Union (EU) as the European Central Bank (ECB) deliberates on a substantial Quantitative Easing package to stimulate the deflation-hit Eurozone. This edition features a series of insights into the recent developments within Europe. Our team of writers specialising in European affairs – Eelis, Jialin, Joshua, and Mingyang – weighs in on a range of pertinent issues that include Europe’s extended period of stagnation, Russian expansionism, as well as talks of a ‘Brexit’.

With times of trouble, come opportunities. This edition also sheds light on exciting new options in trading and investing. Dorothy uncovers the hidden gems in data mining with regards to the financial market, while Wenchen explores the new possibilities of the Shanghai-Hong Kong Stock Connect – a move that highlights China’s efforts for financial reformation.

For our readers interested in pursuing careers in Investment Banking, a change in perspective might put you in good stead! Joshua delves into the implications of the surging wave of regulations imposed on conventional investment banks. As an alternative, Ruofan shares his experience of what it means to serve high net worth clients in a Family Office.

With the crash in oil prices, it is imperative for oil-producing countries to look into viable alternatives for the benefit of their economy. In our partnership with Oxford Business Group, we include a special report on one such oil-producing nation – Brunei – that looks toward diversifying her energy resources.

We hope that this edition would provide our readers with a more comprehensive understanding of the central concerns of today’s world, and help our readers out especially during this period of multiple assessment centres and interviews. On behalf of the Finance Society, we wish you all the best in clinching that job!

Editor-in-Chief Terence Goh

Editors Sherman Lim Rasmus Hogh Design Madeline Lim Contributors Dorothy Wong Eelis Virtanen Jialin Weng Joshua Lloyd-Lyons Mingyang Ni Ruofan Ni Wenchen Chu

CREDITS

04 08 12 15

Europe’s Lost Decade

By Eelis Virtanen

Viability of the Eurozone

By Jialin Weng

Finance and Geostrategy: The Rise of Russian Expansionism

By Joshua Lloyd-Lyons

The Potential for a UK Exit from the EU

By Mingyang Ni

FUNDAMENTALS 19

CONTENTS

MARKETS

Regulation and ‘Robin-Hood’ Policy: The Demise of Conventional Investment Banking?

By Joshua Lloyd-Lyons

27 30

Opportunities in Big Data

By Dorothy Wong

Shanghai-Hong Kong Stock Connect: A Structural Opportunity for A Share

By Wenchen Chu

INSIDE ANALYSIS Exploring New Avenues 35 Brunei:

By Oxford Business Group

CAREERS 38 By Ruofan Ni

Internship at Machlin Oracle

MARKETS

EUROPE’S LOST DECADE And the measures to prevent it

by Eelis Virtanen The US and the UK have experienced strong quarterly growth of 1% and 0.7%1 respectively, whilst the Eurozone economy has still failed to recover to its pre-crisis peak in 2008, reporting a meagre 0.2% expansion in the third quarter. This has led to concerns being expressed on whether Europe’s stagnation has led it to become the new Japan, experiencing its own “Lost Decade” of weak economic performance.

Economic stagnation combined with unemployment has led to the rise of anti-EU parties putting pressure on European leaders, and especially the ECB, to act in order to boost the economy before political

tensions fueled by economic hardships become irreversible. A recent comment by the current US Secretary of the Treasury Jack Lew highlighted this issue: “Resolute action by national authorities and other European bodies is needed to reduce the risk that the region could fall into a deeper slump. The world cannot afford a European lost decade.”2 The idea of Europe embarking on its own Lost Decade paints a grim picture for the future of the currency bloc. After Japan’s crises in the 1990s, growth never returned to the high levels of the 1980s, leading to the subsequent decade coined as the “Lost Decade”, characterized by falling incomes, price deflation, high debt and economic stagnation. The reason why similarities are being drawn between the two economies is that Europe experienced its own economic crises six years ago with recovery still eluding the region.

OECD. (2014) Quarterly National Accounts. Available from: http://stats.oecd.org/index.aspx?queryid=350.

U.S. Department of the Treasury. (2014) Excerpts Of Secretary Jacob J. Lew’s Remarks At The World Affairs Council In Seattle On Building A Stronger Global Economy. Press release. Issued 11/12/2014.

1 2

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MARKETS Joachim Fels, chief international economist at Morgan Stanley, states that “the risk of a Japanification of the euro area is high and rising”3 revealing the increasing fears of long-term economic stagnation in Europe.

lion8, monetary easing will be ineffective. This has placed a larger emphasis on the largely neglected third arrow of structural reform, which consists of more immigration and encouragement for women to enter the workforce.

At present, Japan is a welfare state with relatively unfavorable demographics featuring a shrinking and aging population, alongside a large debt burden and weak economic growth. The parallels with Europe are striking. Japanese Prime Minister Shinzo Abe has embarked on a bold policy nicknamed Abenomics based upon the “three arrows” of fiscal stimulus, monetary easing and structural reform in order to get the economy back on track4.

The target inflation level also has not been achieved, which is necessary due to the large debt levels. Attaining inflation is necessary for countries with high levels of debt in order to allow consumers and companies to increase their economic activity, resulting in a stimulation of economic growth9.

European leaders are studying the lessons from Abenomics with great interest due to the implications it may have with regards to how they will deal with their own crisis. Some may argue that the accommodative stance of the Bank of Japan (BOJ)5 should be copied by the ECB in order to combat the deflationary threat, whilst others may state that it is not needed, and will result in an increase in asset prices only.

The results from Abenomics, with a primary focus on quantitative easing (QE)6 have not been very promising. The most visible results have been the depreciation of the yen and the appreciation of the stock market, Nikkei, to all time highs. However the goal of achieving the target of 2% inflation, set by the central bank by 2015, despite the drastic increase of the monetary base by $712 billion per year, seems unrealistic. Likewise, the forecasted economic growth of 0.5% for 2014 does little to support the cause for Abenomics.

It is clear that not much of the BOJ’s huge monetary stimulus has been transmitted to the real economy, leading to serious questions concerning the effectiveness of Abenomics and whether or not QE actually works. William White, an economist who used to work Bank for International Settlements argues that since Japan’s economic slowdown has been mainly driven by demographics7, with population estimated to fall to 87 million by 2060 from the current 127 mil-

So what does this mean for the ECB and the Eurozone policymakers? Europe currently has a large debt overhang which when combined with weak inflation will make it much harder to manage, forcing consumers to restrict their spending. A clear indication on the extent to which European leaders are willing to go was given by a statement by Mario Draghi: “We will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us”10. However with interest rates having no more room to fall, the ECB is being forced to carry out more unconventional measures in order to combat the crisis.

Currently, the ECB is following a similar path as Japan. It has started to purchase covered bonds and asset-backed securities (ABS) in order to stimulate bank lending and reach the target inflation of 2% set by the ECB. Jean-Claude Juncker, the EU Commissioner has also revealed a £315 billion investment plan for the Eurozone. However the volume of both of these measures is arguably too small to result in anything meaningful, and judging from the results of Juncker’s predecessor, Manuel Barroso, who two years ago initiated a similar investment plan with £180 billion, it seems likely that this new plan will have a very limited effect as well. So it seems bizarre to believe Juncker’s plan would work this time when it has failed in the past. The purchase of ABS is likely meant as a stepping stone for future larger scale QE. So what is the next step for the ECB? After Juncker’s plan was revealed, Mario Draghi stated how more

Bloomberg. (2014) ECB May Repeat Japan Mistake That Triggered Lost Decade. Available from: http://www.bloomberg.com/news/2014-03-05/ecbmay-repeat-japan-mistake-that-triggered-lost-decade.html.

4 Wall Street Journal. (2014) The Next Stage of Abenomics Is Coming. Available from: http://www.wsj.com/articles/shinzo-abe-the-next-stage-of-abenomics-is-coming-1411080939.

5 Antolin-Diaz, J. (2014) Deflation risk and the ECB’s communication strategy. Fulcrum Research Papers. Available from: http://www.fulcrumasset. com/files/frp201402.pdf.

6 Quantitative easing is the act of buying sovereign bonds in order to increase inflation and stimulate economic activity achieved via the expansion of the central bank’s balance sheet 7 White, W. (2014) Japan’s stimulus plan is not courageous but foolhardy. Available from: http://www.ft.com/intl/cms/s/0/5dfdcf52-6e56-11e4-afe500144feabdc0.html?siteedition=uk#axzz3MhyZXp3f.

8 Sieg, L. (2014) Population woes crowd Japan. Available from: http://www.japantimes.co.jp/news/2014/06/21/national/population-woes-crowd-japan/#.VJkqs14Ck. 9 The Economist. (2014) The Dangers of Deflation. Available from: http://www.economist.com/news/briefing/21627625-politicians-and-central-bankers-are-not-providing-world-inflation-it-needs-some.

10 European Central Bank (2014) Monetary policy in the euro area. Press release. Issued 21/11/2014.

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MARKETS action is needed in order to defend inflation expectations. It seems likely that corporate bond purchases will be the next step since the chance of the purchase of ABS in increasing inflation expectations and unblocking bank lending is very small11.

However, there are significant problems with the purchases of corporate bonds. Unlike Japan where the BOJ enjoys more freedom with respect to monetary policy, the ECB is modeled according to the German Bundesbank which has a much tighter stance on monetary easing and a preference for austerity measures in order to combat the crisis. So in the case of buying corporate bonds, serious resistance from Germany is expected since buying them will increase the credit risk, which in turn will limit them only to the most highly rated bonds. To further complicate the matter, the Bundesbank has indicated that corporate debt is overvalued with the search for yield leading to exaggerations in certain market segments, especially in corporate bonds and syndicated loans markets, providing another reason to oppose their purchase. Another problem is that the total volume, even though higher than in ABS, is still going to be too small to have the desired effect.

Thus it may be that to actually affect inflation expectations the ECB will need to purchase government bonds since only they have the sufficient volume and liquidity. Mario Draghi has given indication of increasing the balance sheet of the ECB by 1 billion through engaging in full QE instead of just buying ABS. Governing council member and the chief of the Belgian Central Bank, Luc Coene, stated in an interview that the ECB had already waited too long, and that this could be one tool to spur economic activity in the 18-country euro zone and fight off deflationary pressures12. However concerns over its legal nature as well as the obvious objections of the Germany have arisen. Since this will reduce the pressure on the periphery on structural reforms, it poses a real question on whether it can actually be executed.

It seems likely that if Juncker’s current program has a limited effect on the economy, the ECB will edge towards full-time QE despite Germany’s objections.

However since a large debt overhang exists, pumping more money into the system is unlikely to increase spending and bank lending in the short-term.

This is due to the main focus now on deleveraging and restricted spending until the debt overhang is alleviated.

Even though the ECB will likely embark on this path, other options that are worth considering exist. Eurozone countries might view fiscal easing – with tax cuts for example – as a way to stimulate demand and growth. During an economic downturn with extensive austerity demanded by Germany, the tax increases and reduction in government expenditure has the effect of further weakening demand in the economy – “The boom, not the slump, is the right time for austerity at the Treasury”, as stated by John Keynes13.

For example, the recent consumption tax increase in Japan has reduced consumer spending and reduced this year’s economic growth. So a loosening of austerity measures to a certain extent would give countries in the periphery more breathing room to drive consumer spending up, and allow them to manage their debt levels better since they would have more money available.

Still it must be acknowledged that since Europe is arguably emerging from a balance sheet recession, despite all the actions from the ECB, it will take time for economic agents to deleverage and return to their former spending patterns.

The suggestion from the ECB has been to purchase sovereign bonds proportionally to each country’s contribution to the Eurozone GDP which should reduce some resistance from Germany. On the other hand, this will mean that the German sovereign bonds proportion will be considerably large which is not actually addressing the point – Germany would get the most help even though it needs the least since their yields are already extremely low.

Framke, A. et al. (2014) Exclusive: ECB looking at corporate bond buys, could act as soon as Dec - sources. Available from: http://uk.reuters.com/ article/2014/10/21/uk-ecb-policy-idUKKCN0IA0WK20141021.

12 Thomson Reuters. (2014) ECB’s Coene supports government bond purchases. Available from: http://www.globalpost.com/dispatch/news/thomson-reuters/141220/ecbs-coene-supports-government-bond-purchases-newspaper.

13 Keynes, J. M. (1978) Elizabeth Johnson and Donald Moggridge (eds.) The Collected Writings of John Maynard Keynes. Cambridge: Royal Economic Society.

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MARKETS

VIABILITY OF THE EUROZONE

by Jialin Weng The European Monetary Union (EMU or Eurozone) is different from the European Union. The Eurozone consists of 18 European Union countries which have adopted the euro as their currency. They are Austria, Belgium, Cyprus, Estonia, France, Germany, Greece, Ireland, Italy, Latvia, Luxemburg, Malta, Netherlands, Portugal, Slovakia, Slovenia, Spain and Lithuania (joining in 2015). The Euro was first launched in 1999 and the banknotes and coins were put into circulation in 2002.

The key purpose of this union was to encourage trade and investment by further minimizing transaction costs. It was also hoped that a monetary union would help regulate government borrowing and debt levels to achieve greater economic stability. In the Eurozone, there is one single interest rate set by the European Central Bank (ECB), one inflation target, and member countries agree to keep their fiscal deficit lower than 3%. However, with the Eurozone’s poor performance during its recovery from the 2008 economic crisis, the slow growth and high debt levels in several member countries are pertinent signs of failures. So how viable is the Eurozone in the long term despite certain gains? This article will focus on reasons why the Eurozone has been and is likely to continue being unsuccessful unless certain problems are

overcome. Indeed, the three aforementioned traits of the Eurozone are precisely why it is unlikely to be successful. Overall, the question will be approached mainly through two so called ‘design failures’1 of the Eurozone.

Prior to entry, countries are required to meet certain convergence criteria (or Maastricht criteria). The terms include requirements imposed on inflationary rate, fiscal deficit, debt ratio, exchange rate stability, and long-term interest rate. Notably, quite a few countries did not meet all the criteria for entry in 1999.

For example, Germany, Greece, and Austria’s debt to GDP ratios exceeded 60% the year before entry and were increasing (from 59.7% to 60.3% in Germany, from 63.8% to 64.3% in Austria, and from 111.6% to 113.2% in Greece)2. Hence it could be argued that the Eurozone was built on an unstable foundation, and it was very plausible that Greece would fall into its debt crisis starting from 2009.

So what are the two design failures of the Eurozone?

The current stagnation and slow recovery of Europe and its vulnerability to deflation are, to a large extent,

De Grauwe, P. (2013) Design Failures in the Eurozone: Can they be fixed? Available from: http://eprints.lse.ac.uk/53191/1/LEQSPaper57.pdf 2 De Grauwe, P. (2009) The politics of the Maastricht convergence criteria. Available from: http://www.voxeu.org/article/politics-maastricht-convergence-criteria 1

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MARKETS a result of Germany’s insistence on fiscal austerity and the ECB’s timidity. It is therefore understandable that within the ECB there is a lack of political consensus and policies are often driven by the countries that wield more economic or political sway. Germany’s insistence on deficit reduction and opposition to Quantitative Easing also mean that the ECB had very limited options to boost growth. Thus, the first design failure is that economies within the Eurozone often have very different economic dynamics and often need contrasting policies from the ECB. The second design failure is that a monetary union strips away certain freedoms of economic policies from member countries without giving effective replacements.

Divergences in Economies To start with, let’s look at the divergence in the Eurozone economies as well as the resultant differing boom and bust cycles that make policy-making difficult for the ECB. There are numerous differing aspects, but one key area will be examined here as an example to demonstrate the level of divergence that existed – and still exists – between member countries.

Competitiveness Competitiveness is a result of many factors such as education, health, levels of investment, etc. This has direct impact on an economy’s current account. As exports and imports are important components of aggregate demand, the fact that some countries have current-account surpluses whilst others have deficits could result in uncomplementary economic cycles within the Eurozone. Thus, this makes the ECB’s policymaking extremely difficult in correcting problems within weaker economies without harming the stronger ones. In fact, the Eurozone countries are often segregated into core and peripheral countries, with core countries like Germany having higher labour productivity and hence more competitiveness than many other economies. Indeed, in 2008 Germany’s current-account surplus reached $235 billion, equivalent to 6.4% of its gross domestic product. This is in stark juxtaposition to Spain’s overall current-account deficit which reached $154 billion or 10% of GDP3.

Germany’s economy has also been in a much better condition than many of the other economies after the crisis due to its competitiveness. At the same time, strong demand for German exports means a strong euro. This is a big disadvantage for many peripheral economies and is partly responsible for the slow recovery of the Eurozone countries from the recent 2009 crisis. Thus, one major problem with the Euro-

zone is that the boom and bust cycles amongst member countries are not aligned.

Hence, the question of long-term viability now depends on whether or not member countries can bridge their differences. Many may say that it is only a matter of time before the peripheral countries catch up in competitiveness through investments and labour market reforms. Yet, the truth is that the period of retrenchment these peripheral countries have had already lasted longer than Germany in the early 2000s with no end in sight4. Not only are their losses in trade competitiveness compared to core economies big, their high levels of indebtedness also require firms and households to continue repayment for an extended period of time. The latter invariably depresses consumption and investment. For example, after the austerity measures were enforced across some heavily indebted Eurozone economies, the consumption gap between them and Germany widened significantly. In particular, household consumption in Greece fell sharply to 82% of the EU average from 86% in 2012. In contrast, Germany who was not forced into the austerity program saw its household consumption rise from 123% to 125% of the EU average between 2012 and 20145. Whilst these figures might not be entirely a result of the austerity measures, they reflect to some extent the fact that it would take longer than expected for the peripheral economies to catch up and align with the core ones. More significantly, the measures to facilitate the reforms of some weaker economies may face resistance from others. As of now, it is difficult to foresee a future of convergence.

Inflexibility of Policies At the same time, joining the Eurozone strips its member countries off some crucial and essential stabilising economic policies that previously could have been utilised.

Firstly, the ECB takes the role of central banks and sets a single interest rate for all. This means that the problems of diverging economic cycles amongst member countries cannot be easily corrected as the interest rate would often be too high for stable economies and

Lund, S. & Roxburgh, C. (2009) Imbalances that strain the eurozone. Available from: http://www.mckinsey.com/Insights/MGI/In_the_news/Imbalances_that_strain_the_eurozone 4 Tilford, S. (2014) The eurozone is no place for poor countries. Available from: http://www.cer.org.uk/insights/eurozone-no-place-poor-countries 5 Hannon, P. (2014) Austerity causes Euro-Zone Consumption Gap to Widen. Available from: http://www.wsj.com/articles/austerity-causes-euro-zone-consumption-gap-to-widen-1403095669#livefyre-comment 3

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MARKETS too low for overheating ones. This was demonstrated through the case of Germany, Netherlands, Spain and Greece. Prior to the crisis in 2008, both Germany and Netherlands had mild inflationary rates (CPI) at 2.8 and 2.2 respectively. In contrast, Greece and Spain’s inflation rates reached 4.2 and 4.1.

Secondly, a single currency results in member countries not being able to depend on natural depreciation to boost its competitiveness or long term growth due to a weaker demand. In particular, a strong euro due to relatively high demand for some core Eurozone countries’ exports is disadvantageous for the peripheral economies who, if were not part of the Eurozone, should experience a more positive recovery in the long run from the healthier demand a weaker currency provides.

The loss of freedom in determining exchange rate and interest rate policies has left most countries with limited policy tools. In combination with the current high debt levels, many of the Eurozone countries such as Greece and Portugal were forced into enforcing austerity programmes as the main way to boost long run confidence and growth. In addition, the spending cuts also aimed to reduce fiscal deficit below the set boundary of less than 3%. In fact, the Eurozone members have finally hit its fiscal target since 2008 by reducing their fiscal deficit as a percentage of GDP down to 3% in 20136. However, it is definitely not the best strategy considering the surge in unemployment rate and feeble growth in much of the Eurozone. If we look at the current situation in Europe, the concern of deflation is also a result of excessive austerity. On the other hand, the rule set by the Eurozone on fiscal restriction has not been helpful in preventing the crisis as most countries did not follow it anyway. This was most prominently demonstrated by Greece which had a fiscal deficit of 15.4% in 20097.

that the ECB enforced upon many members in return for ECB funds, leading to very high unemployment in the short run. This leads us to question whether a monetary union is really necessary for growth and investments. In fact, using the IMF data, the investment rate and growth in GDP in the Eurozone countries were down 2% and around 0.5% respectively during first decade of the 21st century compared to the previous decade9. Even if the crisis had not occurred, the economic gain from the euro is not obvious. While the Eurozone may have facilitated some aspects of economic growth in Europe, the benefits may not be worth the costs. Where should the Eurozone head to with so many different interests and various economic situations? The answer remains in whether politicians can successfully reduce both economic and political differences – a political consensus would be indispensable.

To conclude, De Grauwe summarises the situations in Eurozone nicely: “In 1999 I compared the Eurozone to a beautiful villa in which Europeans were ready to enter. Yet it was a villa that did not have a roof. As long as the weather was fine, we would like to have settled in the villa. We would regret it when the weather turned ugly.”8 As we have seen, the 2008 economic slump disastrously exposed the problems within the Eurozone and the ECB simply did not have an effective policy that could help countries to recover without inducing huge social costs.

This was shown through the austerity programmes To Bhma. (2014) Eurostat confirms Greece’s surplus and deficit figures for 2013. Available from: http://www.tovima.gr/en/article/?aid=588904 Watts, W. (2010) Eurostat lifts reservations over Greek Methodology. Available from: http://www.marketwatch.com/story/greeces-revised-2009-deficit-tops-15-of-gdp-2010-11-15 8 De Grauwe, P. (2013) Design Failures in the Eurozone: Can they be fixed? Available from: http://eprints.lse.ac.uk/53191/1/LEQSPaper57.pdf 9 Steinherr, A. (2012) Is Germany the Main Beneficiary of the Euro? Available from: http://www.theglobalist.com/is-germany-the-main-beneficiary-of-the-euro/ 6 7

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MARKETS

FINANCE AND GEOSTRATEGY: THE RISE OF RUSSIAN EXPANSIONISM

by Joshua Lloyd-Lyons

“The search for power is not made for the achievement of moral values; moral values are used to facilitate the attainment of power.” -Spykman When Mikhail Gorbachev, the former leader of the Soviet Union, declared that the world stood on the “brink of a new Cold War”1, leaders of governments and industry took heed. The Ukraine Crisis has catalysed a severe breakdown in Russia-US relations, with wide ranging economic impacts: from a crash in the Rouble to swelling trade sanctions. The current turmoil in the Ukraine raises interesting questions about the lengths to which Putin will go to secure Russia’s economic and geostrategic interests.

There are two prevailing interpretations of Russia’s recent actions: firstly, that Putin was protecting his sphere of influence – as befits a regional superpower. The naval port at Sevastopol is essential to Russian power projection into the Black Sea (as was seen during the 2008 war with Georgia) and Putin moved to prevent pro-European forces occupying a strategic region on the border with Russia. The sec-

ond interpretation is that aggressive expansion into the Ukraine is the natural conclusion of the ‘Putin Doctrine’ (the drive to regain “economic, political and geostrategic assets lost by the Soviet State”2) and that Russia is beginning what amounts to a sustained offensive into Eastern Europe.

This essay will analyse the likelihood and potential financial implications of future Russian expansionism; if Russia were to continue in this vein, there would be far reaching effects on the global economy.

The Financial Implications of an Expansionist Russia Impacts on the Global Economy 1. Government Spending As the first Cold War showed, animosity between great powers significantly influences domestic spending: military budgets are likely to soar as nations build up both their conventional and nuclear arsenals. However, unlike the previous Cold War, Eastern Europe is politically and economically aligned with the West, with NATO expanding eastwards in the post-Cold

Wagstyl, S. (2014) Gorbachev warns World on ‘the brink of a new cold war’. Available from: http://www.ft.com/cms/s/0/9d976eae-676f-11e4-897000144feabdc0.html#axzz3OPCuDtOf 2 Aron, L. (2013) The Putin Doctrine: Russia’s Quest to Rebuild the Soviet state. Available from: http://www.foreignaffairs.com/articles/139049/leon-aron/the-putin-doctrine 1

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MARKETS War era. This means that states like Poland are likely to increase military spending significantly to protect against potential Russian aggression, rather than military spending being limited to two superpowers.

However, military spending comes with major opportunity costs as infrastructure projects and welfare then become secondary to national security – although there can be benefits in the form of job creation and investment in high-tech industry.

2. Trade As we have seen thus far, sanctions and retaliatory sanctions have become political tools in a hostile diplomatic environment. We have seen sanctions damage the EU and cripple Russia and it seems certain that this trend would be perpetuated under an expansionist Russia. This would damage all parties concerned, although Russia would be especially diminished due to her relatively smaller and less diversified economy, compared to the US and EU. Another major point is that Russia supplies a third of Europe’s natural gas3; a tap that could potentially be turned off – if Russia were willing to bear the devastating economic consequences. However, it seems more likely she would bully states within her sphere – increasing prices and restricting supply to nations who incurred her wrath.

3. Political change and Strategic Investment An aggressive Russia would likely be a significant boon to the stability of the European Union as member states would unify against a clear rival. This could potentially push Europe towards a more federal model with a centralised military force, in order to protect itself from Russian encroachment without having to rely on NATO. Nations would also be less likely to leave the EU, when doing so could mean facing the Russian bear alone!

Strategic investment by Europe and perhaps even the US might also occur: nations such as Turkey and Egypt have huge geostrategic import – due to their respective control over entrance into the Black Sea and through the Suez Canal. Investment and influence would likely be brought to bear to keep these nations on the ‘right side’ – this would, naturally, have hugely positive effects for the nations involved.

Strategic investment in certain industries such as shale gas would also enjoy increased spending, as nations seek to protect themselves from the possibility of future Russian aggression.

Impacts on the Russian Economy 1. Commodity Exports Russia has a dangerously concentrated economy – she lives and dies by her ability to export oil and gas at high prices. 52% of federal budget revenue and 70% of total exports come from oil and natural gas and even a moderate decrease in commodity exports could have a detrimental effect4. If Europe sought alternative energy sources, in order to avoid reliance on a hostile power, the Russian economy would be irreparably damaged. Furthermore, the crash in the price of crude oil has exacerbated Russia’s peril as she now has extremely strong incentives to maintain her existing commodity customers – as her projected future budget deficit spirals further and further into the red.

2. Essential Imports As a modern globalised economy – Russia requires certain imports, such as machinery for the extraction of natural gas, which under the current sanctions regime, she will not be able to acquire. Over a sustained period of the time – it is highly questionable whether Russia could effectively operate in an economic vacuum; the effects would be determined by the parameters and implementation of sanctions.

3. Foreign Investment and Forex The recent cataclysmic crash in the Rouble – in part due to sanctions and also because of fears of future geopolitical risk – highlights the major issues Russia faces moving forward. Investment in Russia may decline further due to fears of future sanctions and economic retaliation by Russia against Western powers.

Firms are also decreasing their exposure to Russia – JP Morgan, for example, has reduced its exposure by over 13% this year5, a trend that could be harmful to the Russian economy.

The Likelihood of Russian Expansionism and a Second Cold War Now we have covered the pertinence of this geostrategic issue to the financial world – we must speculate as to the likelihood of a new Cold War. There is an extremely convincing geostrategic theory established by Nicholas J. Spykman, which describes the Eastern European states around Russia as a sort of “Rimland” – which provide a geographical barrier to Russian expansion. Spykman went on to say that “since the time of Peter the Great, Russia has attempted to break through the encircling ring of border states..”6. Robert D. Kaplan, a foreign policy

Henley, J. (2014) Is Europe’s gas supply threatened by the Ukraine crisis? Available from: http://www.theguardian.com/world/2014/mar/03/europesgas-supply-ukraine-crisis-russsia-pipelines 4 US Energy Information Administration. (2014) Russia. Available from: http://www.eia.gov/countries/analysisbriefs/Russia/russia.pdf 5 Campbell, D. & Son, H. (2014) JP Morgan joins BofA, Citi in reducing exposure to Russia. Available from: http://www.bloomberg.com/news/2014-0502/citigroup-joins-bofa-in-reducing-exposure-to-russia.html 6 Spykman, N. (1942) America’s Strategy in World Politics. New Brunswick: Transaction Publishers.

3

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MARKETS expert and geostrategist, elaborated further on Spykman’s thesis declaring, “The competition for the Rimland continued into the Cold War”7. This argument provides an extremely coherent argument for Russian expansion: control of the Rimland would give her greater control of Europe and a much wider reach – allowing her to fulfill the ultimate dream of the Putin Doctrine.

Now a potential motive for expansion has been established, let us turn to logistics: conflict in the nuclear age is an exceptionally difficult issue – proxy warfare is almost infinitely preferable to direct confrontation, as open warfare could create escalation spiral’s leading to a nuclear conflict. The Cold War was punctuated by conflicts that, just like in Ukraine, were fought on a limited scale using conventional means; thus, there is reason to believe that there is at least limited scope for such action in Europe (although any attack on a NATO member state could provoke the threat of nuclear retaliation). To quote Field Marshal Lord Carver: “War therefore, if it is to be a rational “other means” of the continuation of state policy, will have to be conventional and limited. If it is to be limited in its effects, it must, as Clausewitz recognised, be limited in its aims.”8

From this we may conclude that total war in Europe is phenomenally unlikely in the modern era – as not only is Russia greatly outnumbered and outgunned

by NATO in conventional terms – but modern deterrence theory will almost certainly prevent direct conflict between nuclear powers. Nuclear confrontation remains very much a no-win situation.

Conclusions Although all-out war is unlikely – some degree of continuing conflict seems extremely probable; Crimea is too geostrategically significant an asset for Russia to relinquish and Putin’s nationalistic ambition is too great. Financially speaking – anything but minor proxy conflict would be extremely inefficacious for Russian prosperity, as she stands to lose considerably more than Europe. Quantifying and modeling geostrategic risk is easier said than done. A lack of political transparency, a long time horizon, and the complexity of this geostrategic risk further compound this difficulty, although identifying ‘Country Risk’ might provide a useful starting point. All things considered, future conflict and consequent disruptions to trade, commodity markets and government spending seem almost inevitable and banks should create working predictions of future developments – in order to effectively limit exposure and seize potentially lucrative opportunities.

Kaplan, R. (2012) The Revenge of Geography: What the Map Tells Us About Coming Conflicts and the Battle Against Fate. New York: Random House, Inc. 8 Carver, M. (2010) Conventional Warfare in the Nuclear Age. In: Gilbert, F,. Craig, G. & Paret, P. (eds). Makers of Modern Strategy from Machiavelli to the Nuclear Age. Princeton: Princeton University Press.

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MARKETS

THE POTENTIAL FOR A UK EXIT FROM THE EU And the implications of such a withdrawal

by Mingyang Ni The UK is an important member of the EU, yet the UK does not adopt the common Euro currency which is used by most members. The membership of the UK in the EU has always been the focal point of political and economic discussions since the establishment of the European Economic Community (EEC).

The recent poor performance of the EU economies has brought attention back to the question of “Brexit”.

Why is it so difficult to make a choice on whether to be a member of the EU; and what is the potential implication of the” Brexit”?

1

Why did the UK join the EU in the first place?

Ted Heath, the prime minister of the UK from 1970 to 1974 who witnessed the entry of the UK into the EEC, had two main reasons why the UK should join the EEC. Firstly, he sincerely agreed with Jean Monnet, one of the founding fathers of the EU, that cooperation in the form of politics and economics was the best way to avoid another potential war in the future.

Heath also felt it was essential for the UK to anchor its economy with her neighbours for prosperity and stability. It is the largest economic zone in the world and accounts for 16% of world imports and exports1. The EU membership is also the most important source of foreign direct investment (FDI) for the UK, accounting for 45% of FDI in the world. Moreover, in the 1960s, the UK was struggling with her low economic growth and the spiraling inflation rates. The establishment

World Trade Organisation. (2012) International Trade Statistics. Available from: http://www.wto.org/english/res_e/statis_e/its2012_e/its2012_e.pdf

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MARKETS of the European Free Trade Association provided little stimulus to the UK economy, while the trade with the EEC more than doubled since its establishment.

It appeared that joining the EEC was the best option to save her economy at that point in time.

What is needed in order to be a member of EU? In order to be a member of the European Union, a country has to have a stable institutions guaranteeing democracy, the rule of law, human rights and respect for and protection of minorities. A country must have a functioning market economy which is competitive enough to survive in the EU market and a healthy debt to GDP ratio. The ability to fulfil the obligations and political requirements of the EU is also an essential requirement2. The country must promise to cooperate and integrate with other members. After joining the EU, each member country must pay commission fees according to the performance of their economy to the EU budget on a regular basis.

What happened along the way?

In 1973, the United Kingdom finally joined the EEC after a third attempt. However, the EEC has already been set up for 15 years. Most of the rules within the EEC have been set and finalized. As a late entrant into the EEC, the UK had to follow the rules that were set without her involvement and these rules may not have favoured her. The UK regarded the EEC as a common market with benefits to trade and jobs for the UK upon her time of entry. However, shortly after Parliament had approved British entry, French President Pompidou was proposing that member states should make a solemn commitment to “move irrevocably to economic and monetary union by 1980”3. This has deviated away from the original intention of the UK and would have greatly compromised her economic independence. The administration suffered a severe fall in support from the public, but the UK continued to be a member of the EEC. During Thatcher’s administration, her grating personal negotiating style definitively helped the United Kingdom gain some benefits by securing a permanent two-thirds rebate from the subsidies given to French through the Common Agricultural Policy. However, this severely damaged relationships between her and the other European leaders4.

Potential concerns for the “Brexit” 1. Economic Impact Although we cannot deny that the UK will have the ability to negotiate its own trade deals as a large developed country, it has to be done as a single country with a 62 million-strong market rather than as the largest economic zone in the world5. The EU is a vital source of FDI and a huge market for the UK and large transnational companies such as Rolls-Royce could move out of the UK to avoid a costly access to the EU market. Leaving the EU is likely to significantly reduce the UK’s market size and the amount of resources available for investment.

However, the impact on our economy may not be very obvious as, more than 90% of the UK economy does not involve the participation of the EU6. Yet it still bears the burden of its rules, such as the new EU VAT7. The new VAT rule will create a significant burden on the micro-businesses in London. Moreover, the commission fees to the EU budget imposed a significant burden on the UK economy without creating enough returns. The UK’s Net Receipts from the EU budget, based on 2009 budget data was -0.24%8.

This indicates that the UK is benefiting less as compared to her own contributions to the EU. The UK could have allocated the commission fees to the EU to other areas of her economic development.

2. Legal Implications The United Kingdom could lose its benefits from some of the well-implemented and large-scale legislations such as the EU employment laws and social protections. Moreover, implementing different legal system standards may cause inefficiencies while cooperating with other EU nations. It will be less convenient for the UK to cooperate with other EU countries if the UK does not have the same set of rules as them. Different legal systems may also hinder plans on coordinated operations against terrorist activities.

However, leaving the EU enables the UK to attain an independent legal system that suits her own needs. It is entirely possible for the UK to maintain the legislation in the EU which are beneficial. At the same time, the UK will not have to compromise its efficiency in legal system to be a member of the EU. From 1997 to 2009, 6.8% of primary legislation and 14.1% of sec-

European Commission. (2014) Conditions for membership. Available from: http://ec.europa.eu/enlargement/policy/conditions-membership/index_ en.htm 3 Booker, C. (2011) Britain and Europe: The Culture of Deceit. Available from: http://www.brugesgroup.com/eu/britain-and-europe-the-culture-of-deceit.html 4 Gilligan, A. (2012) The EU: so where did it all go wrong? Available from: http://www.telegraph.co.uk/news/worldnews/europe/eu/9770633/The-EUso-where-did-it-all-go-wrong.html 5 Watt, N. (2013) Britain and Europe: the essential guide. Available from: http://www.theguardian.com/world/2013/jan/18/britain-europe-eu-essential-guide 6 British Broadcasting Corporation. (2013) UK and the EU: Better off out or in? Available from: http://www.bbc.co.uk/news/uk-politics-20448450 7 Dann, K. and Ross, E. (2014) New EU VAT regulations could threaten micro-businesses. Available from: http://www.theguardian.com/small-business-network/2014/nov/25/new-eu-vat-regulations-threaten-micro-businesses 8 Heinen, N. (2011) EU net contributor or net recipient: Just a matter of your standpoint? Available from: http://www.dbresearch.com/prod/dbr_internet_en-prod/prod0000000000273546.pdf 2

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MARKETS ondary legislation was introduced in the UK to implement EU obligations9. The Common Agricultural Policy exemplifies the inefficiencies of the EU policies: A significant amount of the EU budget which could have been used in other areas of development that was spent in maintaining minimum prices on agricultural products which severely distorted the market.

This also leads to an unnecessary rise in the cost of living due to the high prices of agricultural products.

3. Alternative Options Other EU nations will not allow the UK to remain in the EU to enjoy its benefits while on a radically different set of terms that attempts to avoid its responsibilities. David Cameron argued in his speech last year that the UK cannot be involved in the rule making process if the UK opted to remain in EU on the

new terms10. The rules set are unlikely to favour the UK when they are devised without UK’s presence.

However, the UK could leave the EU and still maintain close trade and political cooperation with other EU nations. Norway and Switzerland are not members of the EU, but still continue to benefit from the close relationship they have with the EU, though with the payment of commission fees. The UK could also choose to break away from the EU completely and this may be a stimulus to the currently stagnant economy in the UK. Breaking away from the EU will also force the UK economy to find more efficient or innovative ways of doing business in order to survive as a relative smaller market. Although this is very risky, innovation is one of the most effective ways to significantly boost UK’s mature economy.

Figure 1: Net contribution to EU budget by country11 Miller, V. (2010) How much legislation comes from Europe? Available from: http://www.parliament.uk/briefing-papers/RP10-62.pdf 10 British Broadcasting Corporation. (2013) UK and the EU: Better off out or in? Available from: http://www.bbc.co.uk/news/uk-politics-20448450 11 British Broadcasting Corporation. (2009) Paying for the EU budget. Available from: http://news.bbc.co.uk/1/hi/world/europe/8036097.stm 9

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MARKETS If the UK leaves, what will happen to the EU then?

The UK constitutes the second largest contribution to the EU budget by net contribution. The UK Treasury estimates that the net contribution to the EU budget from the UK is £8.6 billion last year12. If the UK leaves the EU, the first immediate result will be a fall in the amount of budget available to the EU. Consequently, the burden on other member states, especially Germany, the Netherlands and France, will significantly increase.

A British departure will greatly tarnish the image and dignity of the EU, as well as the current economic and political stability. Some people believe that a dominant culture of deceit exists within the EU. Countries are remaining in the Union to obtain as many benefits as possible for their own countries. For example, the rules of the EU set by France were a deliberation made to hide its weaknesses, such as the shorter working hours on average as compared to other countries. Paris is still reluctant to carry out structural economic reform as long as it is still able to borrow sufficient money from its bond market13. This makes hope for a reform in the near future is fairly slim.

The exit of the UK may provide an impetus for the French to break away from the policies which have constrained their economy. It is not impossible for cooperation to break up under the pressures generated

by a British departure as a new layout of responsibilities is likely to lower their tolerance towards each other. The additional burden and potential detriments on the EU countries may push them to think about a departure as well.

The end?

We will not know the result until the British holds its referendum in 2017 if David Cameron is re-elected.

From the current poll on the public, we should expect a “Brexit” to happen. The influence of the “Brexit” will not be limited to Britain, and will definitely have a deep impact on the lives of every European, along with a significant change in the political and economic formation of the world.

It seems that a “Brexit” is more likely to happen. The size of the EU creates multiple levels of bureaucracy and reduces the efficiency of the EU. Leaving the EU will probably enable the UK to make more timely and suitable changes to its policies. Moreover, the UK economy is already fully developed. It is unlikely to improve significantly unless a new stimulus is introduced. Exiting from the EU will force the UK to find alternative ways to develop her economy. Inevitably, the risk on the UK economy is high, but it is one that is worth taking in order to achieve higher economic growth and global influence.

Chan, S. P. (2014) UK could be plunged into another crisis if it left EU. Available from: http://www.telegraph.co.uk/finance/economics/10836358/ UK-could-be-plunged-into-another-crisis-if-it-left-EU.html 13 White, M., Elliott, L. and Higgins, C. (2014) What if Britain left the EU? Available from: http://www.theguardian.com/politics/2014/nov/04/what-ifbritain-left-the-eu-europe-politics-economy-culture 12

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FUNDAMENTALS

REGULATION AND ‘ROBIN-HOOD’ POLICY: THE DEMISE OF CONVENTIONAL INVESTMENT BANKING?

by Joshua Lloyd-Lyons

In 2008 the financial landscape was ablaze, but before the dying cinders of Lehman Brothers were finally extinguished, governments and regulators – stirred by a public hatred of investment banking – set to the task of preventing future catastrophe. It was from this atmosphere of panic and global hysteria that the first seeds of modern financial regulation were sown; the lamentable shrub that has grown manifested as the DoddFrank Act in the United States, the European Market Infrastructure Regulation in Europe and the BASEL accords. Although undoubtedly well-meaning, this regulation

has already led to a precipitous change in the nature of Investment Banking and will continue to dramatically change the ways in which banks do business; with dramatic economic implications for the world at large. Governments loudly decry banks for failing to lend, while quietly ratcheting up requirements on the capital and liquidity that banks are required to hold; it should be no surprise to this magazines undoubtedly informed readers that the flow of credit has gone from a torrent to barely a trickle. The purpose of this article, then, is to probe the nature and extent of these chang-

es that have violently swept the City, and to speculate as to the future of investment banking; an issue as inviolably bound with the economic fate of Great Britain, as with the careers of many readers.

I will first explore the spheres of investment banking that the spectre of regulation will beleaguer: looking at the implications of changes to capital structures, leverage, liquidity, systemic risk/traded products and remuneration. I will then look at the role non-bank entities can play in filling conventional roles through the sector referred to as ‘Shadow Banking’.

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FUNDAMENTALS Capital Probably the greatest impact of regulation on investment banking comes in the forms of restrictions on capital and leverage.

Capital Requirements Capital requirements form a key tenet of Basel III and remain an area of emphasis for regulators: both on increasing the quality and quantity of capital held by banks. Under the first ‘pillar of Basel III’, there will be a greater focus on common equity and the minimum amount banks are required to hold will be raised to 4.5% of total risk-weighted assets, up from 2%.

Furthermore, to counter pro-cyclical behaviour – there will be a very sizeable capital buffer, which can be imposed, of up to 2.5% of capital - if regulators believe there is a build up in systemic risk.

Finally, there is a ‘Capital Conservation Buffer’ – of 2.5% (composed of Tier 1 Capital) above the regulatory minimum capital; which constitutes a significant increase. If banks fall within this range, then strict constraints on the distribution of capital will be placed on the bank in question – something which firms are understandably keen to avoid.1 However, there could be significant negative effects arising from this so-called ‘Macroprudential policy’; a reduction in bank lending and return on equity seems extremely probable. In the short run, banks will need to increase their levels of capital – which will likely be raised through equity and dividend retention2. The cost of bank lending will also likely increase, as less capital will be available for lending out and due to the costs to banks of implementing regulation. There is a clear opportunity cost of capital retention – as banks cannot most effectively utilise all of their assets.

Leverage The contemporary wisdom is that one of the most significant contributory factors to the financial crisis was that banks became extremely leveraged- both on and off their balance sheets. Off-balance sheet levering came largely through Special Purpose Entities (SPE’s) – entities used to hold structured assets – and certain derivative products. The issue with this levering is that it makes banks more susceptible to losses – the result of which was seen in the panic de-levering which occurred during the financial crisis.

Basel III proposes a “simple, transparent, non-risk based leverage ratio”3 – which aims to capture both

on and off balance sheet leverage. It is expressed as Capital Measure/Exposure Measure – with this ‘Capital Measure’ constituting Tier 1 capital (core capital such as equity) and the ‘Exposure Measure’ comprising of on-balance sheet exposure, derivative exposure, securities financing transaction exposure and off-balance sheet items4. This regulation is especially comprehensive – when looking at derivative risk, as it aims to capture both the underlying risk of the derivative and the counterparty risk inherent in the product.

Basel III sets the minimum requirement at 3% or in other words:

From the point of view of stability, this measure makes excellent sense – it prevents banks from exposing themselves to excessive risk and makes them more able to recover from financial shocks. However, leverage is also a hugely beneficial tool – debt has performed an essential economic function since well before the days of Adam Smith; namely, increasing growth and return on equity. Therefore, by placing safeguards on levels of debt to equity – companies may have their growth and revenue generation potential severely stunted. In certain cases, very high levels of leverage may be entirely warranted; the disadvantage of the measure not being risk adjusted is that high leverage may be extremely advantageous for low risk assets i.e. areas of trade finance, where customer default rates range from 0.03% to 0.2%5, and the rate of recovery given default is also exceptionally high. One might speculate that considering the ratio is not risk-adjusted – banks might prioritize high risk lending over something such as a household mortgage.

Liquidity The Liquidity coverage ratio (LCR) aims to improve a bank’s response to short-term adverse conditions simulated over a 30-day period. This is to ensure that banks have sufficient liquidity to survive the sort of ‘bank run’ that Northern Rock encountered in the UK. This stress test essentially weighs up the firms’ assets (which are given a liquidity rating – cash and cash equivalent’s are 100% of value, while corporate bonds receive only 50%) against the sort of cash-outflows they would expect over this 30-day period of ‘stressed funding’. Another liquidity regulation is included in Basel III; Net Stable Funding Ratio (NSFR), this aims to act, over the long term, to reduce the risk of future liquidity shortages. This measure tackles a banks funding, or rather the stability of said funding.

Bank for International Settlements. (2011) Basel III: A global regulatory framework for more resilient banks and banking system KPMG. (2011) Basel III: Issues and Implications 3 Bank for International Settlements. (2014) Basel III Leverage Ratio Framework and Disclosure Requirements 4 Ibid.

5 International Chamber of Commerce. (2014) Global Trade set to benefit from ICC Report 1 2

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FUNDAMENTALS A bank’s secure funding should be greater than or equal to required funding.6 These measures are intended to improve the stability of the sector as a whole, by reducing the impact of a ‘bank run’ on individual firms. However, there are major costs for the firms involved – holding large amounts of liquidity holds a major opportunity cost, as it can’t be invested in potentially riskier and more lucrative ways, which will reduce the return to equity of these firms. Borrowers may also have to look elsewhere as lending falls in the face of the increasing drive to increase and maintain liquidity. One might speculate that this will change banks’ lending habits, increasing the prominence of riskier assets with higher returns as the opportunity cost of lending increases.

Systemic Risk and Traded Products ‘Systemic risk’ is a broad term that encompasses aspects of capital and liquidity regulation, however, other specific measures are being introduced that are meant to create stability and ‘market harmony’. There are three central pieces of legislation that are pertinent to this topic: Basel III, the Dodd-Frank Act and MiFID [‘Markets in Financial Instruments Directive’ – a keystone of EU financial regulation].

Basel III, firstly, aims to tackle exposure from complex securitisation. It strengthens the capital retention requirements, thus creating a “harmony of interests” whereby banks have a vested pecuniary interest in the outcome of the securitisation. This of course carries an opportunity cost for banks and may lead to fewer securitisations and thus, a reduction in distressed firms access to capital. This will undoubtedly precipitously change the way in which structured finance operates.

Secondly, Basel III tackles the issue of Counterparty Credit Risk (CCR). This focuses on derivative exposure through stress tests, changes to risk management standards and modifications in the way in which certain types of risk are measured, along with efforts to increase transparency7.

monitor. Chains of credit – where banks would pass on loans to other banks – emerge that are essentially impossible to monitor or hedge against. As a 2012 Bank of England report puts it: “The financial system is a domino line.”8 This is, naturally, even more dangerous in the case of Over-The-Counter (OTC) derivatives, which are sometimes used as part of a broad hedging strategy. Strengthening these safeguards seems like a legitimate way of reducing systemic risk.

Thirdly, Basel III stipulates that increased levels of capital must be retained for derivative activity, in addition to an ‘improved’ Value at Risk (VaR)9 framework. There will be capital charges against credit value adjustment volatility risk (CVA) – which will have a significant impact on certain products such as OTC derivatives.10 Changes to derivatives will naturally hinder the ability of banks to trade these products effectively, also increasing the cost of hedging risk.

The Dodd-Frank Act creates organisations such as the Financial Stability Oversight Council (FSOC) – which monitor large interconnected institutions that are supposedly ‘too big to fail’ – in order to prevent negative implications for the system as a whole.

The mandate of the US Securities and Exchange Commission (SEC) is also increased to include the responsibility to evaluate financial ratings given by agencies, as well as increase its ability and mandate to ‘protect investors’ in the case of complex securities. Furthermore, the Dodd-Frank Act imposes risk retention in the case of securitisations of 5%.

The Volcker Rule is one of the most significant elements of the DoddFrank Act. In essence, it aims to prevent banks entering into speculative investments on their own balance sheets – and also seeks to place limits on their relationships with hedge funds –

During the crisis, it became very evident that CCR had been underestimated, since it is extremely difficult to Bank for International Settlements. (2013) Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools Accenture. (2013) Counterparty Credit Risk and Basel: A Framework for Successful Implementation 8 Haldane, A. G. (2012) On Counterparty Risk 9 VaR is a method of quantifying firm-wide or portfolio-wide risk over a period of time – it takes into account the size of the risk, the probability of that risk coming to bear and the time period.

10 Bank for International Settlements. (2012) Fundamental Review of the Trading Book 6 7

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FUNDAMENTALS

which amounts to an all out assault on proprietary trading.

The main impact on the way in which investment banks operate comes from the Volcker rule – proprietary trading and speculative trading was a huge source of revenue for firms and the devastating limitations of regulation have and continue to cause significant change in banks’ business models, forcing them to increasingly provide capital to only individuals and businesses. The effect of this cannot be overstated: long gone are the days of cigar toting, liar’s poker playing, prop-traders making millions on a roll of the dice.

The MiFID11 is a European Union Directive aimed at creating stability through transparency and investor protection. Increased levels of due diligence and disclosure are intended to improve the safety of investors, while the directive also seeks to increase the transparency of OTC markets by introducing a number of disclosures, both before and after any trade takes place. There is also a major effort to centralise 11 12

Both MiFID I and II are referred to collectively for the sake of simplicity.

KPMG. (2012) MIFID Matters: Accessing the Wider Agenda

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the trading of OTC products.

The outcome of this legislation is relatively simple: it will increase transaction costs hugely; increase the time and manpower necessary to complete a trade and reduce flexibility, thus increasing costs, when hedging. While this legislation will undoubtedly bring certain benefits, it will also retard previously dynamic and profitable areas.12 Employee Remuneration and the Public attitude to Investment Banking Restrictions on employee remuneration will have profound – but differing impacts on the industry and on the relative attractiveness of investment banking as a career path. However, they have largely the same origin: the rabid baying of the indolent mob. Partly due to the financial crisis and partly because of a deep-rooted sense of envy and jealously, taxation of the financial services sector is becoming increasingly politically popular. This issue is especially pertinent considering that Britain has recently dropped its legal challenge against ‘CRD 4’, a piece of European legislation that seeks to cap bonuses to 100% of an-

FUNDAMENTALS

nual salaries (with some flexibility to increase this to 200%)13. This will, of course, lead to a serious brain drain away from the UK and will seriously damage its prominence as a financial centre: which investment banker in their right mind would sacrifice a significant percentage of their income for the pleasure of working in the city – especially when the UK already has a rather aggressive income tax regime? One might argue that bankers will simply have their salaries increased. However, this creates significant issues with linking pay to performance and creates inflexible fixed costs for banks, which will damage their competitiveness and flexibility. It is the ‘eat-what-you-kill’ mentality that has made areas of the city extremely productive; removing this lucri causa could be extremely destructive to individuals’ motivation and thus market-wide performance.

What is most prominent, however, in this debate about slashing bonuses is the profound lack of rationale from advocates of such reform. Many people seem to see bonus capping as a way of ‘curbing the excess of the city’, or of punishing the bankers who ‘took all our money’. It is punitive rather than 13

constructive, and it takes no interest in the broader picture, but appears to simply offer the sort of blood sport the masses (or certain unwashed-looking, circumloquacious comedians) so often enjoy. There are coherent arguments about tackling short-termism within banking – by changing the bonus systems to reflect long-term success, without extirpating the concept of variable pay (such as through increased bonus claw-backs); however, it is remarkable how rarely they are made. It is of much concern that it is this same lynch-mob mentality that will drive future regulation – how someone who thinks the FTSE is a method of clandestine flirtation should have any say over how a private firm is run.

The Cumulative Effect on Banks The long run effects of regulation on investment banking are far from clear, however, it seems relatively certain that there will be a dramatic impact on their cost-structures and consequently some major shifts in the focus of their operations. The body of regulation will make a whole host of activities more expensive, as well as forcing them to shoulder the burden of holding increased capital and liquidity, all

Freshfields Bruckhaus Deringer. (2013) New EU rules on bankers’ pay (including the bonus cap)

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FUNDAMENTALS while deleveraging In fact, EU banks could have deleveraged as much as £1.8 trillion worth of assets from their balance sheets since the start of the crisis14. Revenue generation will certainly suffer in the short to mid term and lending from banks will fall, as firms are forced to spend excessively on adherence to various bits of legislation. The restrictions placed on propriety trading will be especially damaging to revenue generation since this used to be an area in which banks could make vast returns. Bonus capping will lead to a serious brain drain from conventional investment banking; the best and brightest would often see this as a golden career path, however, with fewer opportunities and less pay – investment banking’s halo seems somewhat faded. The regulation of derivatives will also cause widespread damage making hedging risk significantly more expensive and less efficient, as well as robbing banks of a lucrative market.

The long-run aspect to emphasise is the reduction in efficiency and the increase in costs that will occur due to regulation: banks will have significantly more bureaucracy and will have to conform to very stringent standards of capital, liquidity etc. This leaves the door open for similar, but unregulated, institutions to gain a competitive advantage while operating in the sphere of conventional investment banking.

What alternatives to conventional Investment Banking exist?

In light of the fact that Investment Banking will be less efficient in conventional domains, we are brought to question: which institutions will fill the funding void that regulation will leave behind? The answer, I believe, is the sector known as ‘Shadow Banking’. The IMF describes shadow banking in the following manner: “If it looks like a duck, quacks like a duck, and acts like a duck, then it is a duck –or so the saying goes. But what about an institution that looks like a bank and acts like a bank? Often it is not a bank – it is a shadow bank”15. Beyond the poorly concealed animosity, the definition is sound: a shadow bank is an institution that fills the role of an investment bank, providing lending, securitisations etc, without actually being an investment bank. Examples are certain private equity firms, hedge fund, money market funds and other alternative investment funds. Although the Dodd-Frank Act has had some impact on Hedge Funds, the effect is utterly insignificant in comparison to the impairment suffered by investment banks.

The scale of Shadow Banking is inherently difficult to accurately quantify. However, it is estimated by the

Financial Stability Board [FSB] to be worth around $75 trillion worldwide, up from $60tn in 201216. There is interplay between traditional banks and the entities that make up the shadow banking ‘sector’, which results in some rather interesting challenges in terms of quantifying and legislating around systemic risk.

Shadow banking tends to perform both securitisation and credit intermediation functions17; both of which are economically essential, especially in the current environment of low bank lending. In a 2013 survey, around one third of European SME’s said they had not been able to access as much financing as they had planned18. Considering that global ‘cross-border capital flow’ contracted from €8.5 trillion in 2007 to €3.3 trillion in 201219, this credit-void will become an increasingly critical issue – one that will have to filled by non-bank credit intermediation.

Now we have established a clear need for lending and the entities that could provide it, it is useful to look at the different scenarios in which future events could play out. If growth continues to falter across much of the world – then there will be a very interesting situation, in which banks that are currently averse to lending are even more wary. Over such a period, much of the regulation referred to in this article will be phased-in, creating vast short-run costs and thus lowering lending further. In such a scenario, non-bank financial entities would become absolutely essential in providing credit to enterprise and would likely experience rapid growth.

If, however, the global economic outlook is more favourable over this ‘phasing-in’ period – banks will likely be hit less hard as they are able to utilise increases in their revenue to fund activities, such as deleveraging, and would be able to lend more.

Whatever occurs, banks will be holding rather than actively utilising certain assets to generate returns – which will directly induce the emergence of a larger Shadow Banking market, populated by institutions that do not have to conform to these regulations and dramatically change their cost-structures.

The only real caveat to the argument on the future growth of shadow banking is that future regulation may come in to dam the flood of credit. Governments are fearful of their own shadows in the current climate and instead of seeing Shadow Banking as the cornucopian response of the free market to a credit shortage; they see something that is to be feared.

This hysteria can be seen in the latest IMF stability

Mukadam, M. & Zilkha, N. M. (2014) Alternative’s Capital’s Role in Rebuilding Europe’s Economy for the Long Term Kodres, L. E. (2013) What is Shadow Banking?

16 Financial Stability Board. (2013) Strengthening Oversight and Framework of Shadow Banking 17 Financial Stability Board. (2014) Global Shadow Banking Monitoring Report 18 European Commission. (2013) SME’s Access to Finance Report 19 McKinsey & Company. (2013) Financial Globalization: Retreat or Reset?

14 15

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FUNDAMENTALS report; they would impose “macro-prudential measures” to save firms from themselves, and seek to protect the world from all systemic risk and instability.20 This knee-jerk reaction, while hardly surprising, would be extremely detrimental to the recovery and future growth of the global economy.

petent graduates who are traditionally fast-tracked into investment banking – there is certainly reason to pause and consider what sort of career trajectory would be the most stimulating and lucrative.

Conclusion There will always be a place for conventional investment banking. Companies are always going to take each other over and banks will always lend to one another. However, this demand seems set to lessen considerably over the coming years. The days of exorbitant bonuses and drunken lunches appear to be over, heralding a new balance of power, with dynamic and largely unregulated shadow banks growing in prominence, as they are able to react to challenges and embrace opportunities with a rapidity and dynamism that investment banks cannot emulate. Traditional investment banks are financially essential institutions and will continue to be so. However, regulation will drive a move towards different cost-structures and different areas of emphasis, as can be seen in the 30% decline in revenue for Investment Banks between 2009 and 201221. For those young highly-com20 21

International Monetary Fund. (2014) Risk Taking, Liquidity and Shadow Banking: Curbing Excess While Promoting Growth The Economist. (2012) Dream turns to nightmare

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the analyst | 25

FUNDAMENTALS

Begin a journey defined by you.

Graduate & Internship Opportunities As we set out to shape the future of Barclays, we’re looking to our graduates to be a driving force. Your readiness to explore new ways to make things better will help us move forward. And our support will make sure that you progress too.

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the analyst | 26

Barclays Bank PLC is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.

Barclays Bank PLC is registered in England. Registered number 1026167. Registered Office: 1 Churchill Place, London E14 5HP.

FUNDAMENTALS

OPPORTUNITIES IN

BIG DATA

by Dorothy Wong

Data capabilities have grown exponentially in recent decades alongside widespread growth in the use of the internet. It has been observed that large bodies of real-time information such as search engine queries, social networks (message boards, blogs, instant messaging), and elsewhere, can be analyzed to yield insights into epidemics and aggregate outcomes of individuals’ behaviours and decisions, in areas such as the financial markets.

In this article I will review some interesting studies made on the application of Big Data to the financial markets. The hypothesized uses and applications of Big Data go beyond sentiment analysis. Many financial agents already incorporate real-time Big Data feeds into their trading decision models, so I will explore what some of the possibilities might be. The chosen studies are mostly concerned with the predictive value of such data sources i.e. if there exist signals that are correlated with an actual movement or event in the financial markets, which are significant and can be used for prediction.

1

Twitter alerts for “changes in context” that enforce trading breaks improves automatic trading.

Automatic trading programmes are often used for efficiency in implementing certain trading strategies, but can be slow to respond to changes in circumstances, resulting in sudden and large losses as trends sharply reverse.

The first step to accommodating such events is to have a circuit-breaker that prevents the algorithm from trading in circumstances that have changed and are now uncertain. A question worth asking, then, is: do signals exist in Big Data that can be used as an early indicative warning?

In “Predicting break-points in trading strategies with Twitter”1, the authors found that change points in financial time series could be predicted by Twitter feeds. They hypothesized that breakpoints are usually linked to factors outside the markets; especially breaking news or difficult-to-capture changes in the socio-political context. They expected that these

Armstrong, M. Vincent, A. (2010) Predicting break-points in trading strategies with Twitter [Online] Available from: ssrn.com/abstract=1685150

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FUNDAMENTALS events create a buzz on the internet, especially as they are being quickly shared around on social networks. Monitoring this buzz might give an advance indicator ahead of reporting by mainstream news channels and a market response.

The authors compared the performances of two algorithms in the Forex market, which as a global market of currencies is sensitive to many news-worthy events and crucially, are highly liquid. They pitted a hybrid algorithm – designed to cease trading activity and re-learn after an alert – against a benchmark algorithm and found that the hybrid delivered superior returns over a 5 month period. They also discovered an unexpected relationship between performance and the lag between the alerts and algorithm’s response. Specifically, performance peaked at 3-4 minutes lag, and not immediately after as one would have reasonably expected.

The study used an alert window of 1 minute – of interest for very active but not high frequency trading – during which there are typically 2-10 warnings of micro changes in context per day. Improving on previous change-in-context big data studies, trigger words included those not usually found in the financial lexicon, which expanded the scope and coverage than studies that only did.

In 62% of the cases, the hybrid algorithm performed better than the benchmark algorithm, posting an average monthly gain of 1.26% versus the benchmark’s 0.56%2. However, returns also appeared to be more volatile, with hybrid losses overshooting the benchmark’s during the more extreme circumstances (close to 5% or more), and it also lost 2.5 percentage points more than the benchmark on an occasion, or nearly twice the average gain of the benchmark algorithm. However, when transaction costs are factored in, the hybrid would improve returns even more as order numbers – and hence costs – are reduced during the break periods of no trading.

These results were achieved with a lag time of 1-2 minutes but the authors also found that narrowing that gap did not give any additional advantage. They found that the algorithm had up to 5 minutes after each alert to profit, with 3-4 minutes postalert being the most profitable time.

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Can search query data be used as trading signals?

In “Quantifying Trading Behaviour in Financial Markets Using Google Trends”3, it was found that changes in Google search query volumes exhibited patterns that could be used as early signals of the Dow Jones Industrial Average (DJIA) movements for trading on longer timescales. The authors of the study found that during the period 2004 to 2011, analysing Google Trends search query volumes of certain terms (chosen for a financial bias) could be profitably applied to long and short strategies carried out on a weekly basis. Further analysis revealed that the differences in performance of different terms could be partially explained by their extent of financial relevance.

The authors also found that strategies worked better when based on US search data rather than global ones, supporting the observation that investors prefer to trade on their domestic market, even in the case of globally significant markets like the DJIA. A related study, “Web Search Queries can predict stock market volumes”4 found that trading volumes could be predicted from search volumes. To be specific, changes in query volumes are followed by peaks in trading volumes by a day or longer. Curiously, these changes emerged from the collective but seemingly uncoordinated activity of many users.

The authors explored the possibility of such a relationship existing between query volumes and trading volumes on a daily scale; if query volumes could predict market movements and thus be used as a proxy for liquidity and volatility. Whilst there is no hard and fast rule about relationships between volatility and security price, liquidity and volatility are generally essential to the profitability of active trading and market making, especially in large banks.

FUNDAMENTALS Their results were that the time series of both volumes tended to peak in a close proximity to each other, indicating a clear correlation. Query volume tended to peak first, 1 to 3 days earlier than trading volume, and cross-correlation coefficients between present query volumes and future trading volumes appeared to be larger than the coefficient of the opposite case, supporting the predictive value of query volume. This is crucial to the theorized relationship or else it would be very possible or even likely that a very logical opposite scenario is taking place: peaks in trading volumes generate enough marginal interest in market participants and followers to create peaks in query volumes.

The authors also observed the behaviour of the users being studied and found that most did not regularly check a wide portfolio of stocks, but searched for a single favourite, and only once, suggesting that they were not financial experts. This indicates that query volume data is not being drawn from the same pool of information as most financial market knowledge, and adds a new tool to assist in trading. Searches also displayed no consistent pattern over time. The surprising conclusion is that the predictive value of query volumes comes predominantly from the collective behaviour of non-experts.

folio. The strategy is still successful even when not immediately executed. It outperformed the benchmark – essentially a buy and hold strategy – with a Sharpe ratio6 twice that of the DJIA. Also, waiting a week to rebalance the portfolio and yet another to realise gains or losses reaps higher payoffs than rebalancing immediately and realizing gains or losses during that period.

In conclusion, the findings of these studies are but a small fraction of the fascinating uses that big data has been shown to have. As data capabilities improve and more and more accessible data is generated each day, these studies hint of the gems to be found in data mining.

Expanding Query Data use even further: Risk Diversification The ways in which Google Trends could be used for is expanded in “Can Google Trends Search Queries Contribute to Risk Diversification?”5, where the author builds on previous studies indicating a correlation between search query volumes and financial market movements. It was hypothesized that the search volume popularity of a stock was positively correlated with its riskiness – as measured by variance – for various reasons. Similar to how contrarian strategies pick lower-performing stocks and eschew high-performing ones in belief of a future reversal due to fundamentals, the author constructed a portfolio that gave low weighting to a popular stock and a higher weight to the least popular stocks. This was tested against a benchmark index – the Dow Jones Index – as well as a uniformly weighted portfolio.

Interestingly, the Google Trends strategy reached a lower risk level than the uniformly weighed portfolio, supporting the hypothesis. And its standardized return also outperformed the uniformly weighted portGenerally, any trading returns more than 0.1% is considered significant Pries, T. Moat, H. Stanley, H. (2013) Quantifying Trading Behaviour in Financial Markets Using Google Trends. Scientific Reports. 3. Article 1684 [Online] Available from: http://www.nature.com/srep/2013/130425/srep01684/full/srep01684.html 4 Bordino, I. Battison, S. Caldarelli, G. Cristelli, M. Ukkonen, A. Weber, I. (2012) Web Search Queries can predict stock market volumes. PLoS ONE. 7(7). Available from: http://www.plosone.org/article/info%3Adoi%2F10.1371%2Fjournal.pone.0040014 5 Kristoufek, L. (2013) Can Google Trends Search Queries Contribute to Risk Diversification? Scientific Reports. 3. Article 2713. Available from: http:// www.nature.com/srep/2013/130919/srep02713/full/srep02713.html 6 A measure of return for the risk level exposed to 2 3

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FUNDAMENTALS

SHANGHAI-HONG KONG STOCK CONNECT A structural opportunity for A share

by Wenchen Chu China is really making a big move this time. Over the last 7 months, there has been heated discussion regarding the announcement of the Shanghai‐ Hong Kong Stock Connect, and the domestic market has reacted positively. What then, is this novel innovation? And what will it bring to Mainland China?

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What is Shanghai‐Hong Kong Stock Connect On April 30, 2014, China’s Premier Li Keqiang made a keynote speech in Boao Forum of Asia when he mentioned the concept of the Shanghai‐Hong Kong Connect (or Hu Gang Tong). Since then, the markets have been waiting for its formal trial. It is a programme aimed at connecting the stock markets in Shanghai and Hong Kong. To be specific, mainland investors will be able to purchase Hong Kong listed stocks through mainland brokers and Hong Kong investors can purchase mainland listed stocks through Hong Kong brokers. While all Hong Kong investors

FUNDAMENTALS

are eligible to trade, mainland investors are required to have over 500,000 RMB in their accounts to trade with the Shanghai‐Hong Kong Stock Connect.

Hong‐Kong investors are able to trade 568 stocks which meet certain criteria in the northbound trading. For example, eligible stocks must be listed on both the mainland and Hong Kong stock exchanges.

Meanwhile, mainland investors will have access to 264 stocks which meet similar criteria in the southbound trading.

During the trial, there will be restrictions on the trading amount, namely the aggregate quota and the daily quota. The Northbound Aggregate Quota is set at RMB 300 billion, while the Southbound Aggregate Quota is set at RMB 250 billion. The Northbound Daily Quota is set at RMB 13 billion, and the Southbound Daily Quota is set at RMB 10.5 billion. In equations, they are displayed as: (1) Aggregate Quota balance = Aggregate Quota – Aggregate Buy Trades + Aggregate Sell Trades (calculated at weighted average cost)

(2) Daily Quota Balance = Daily Quota – Buy Orders + Sell Trades + Adjustments These quotas are calculated on a “net buy” basis, meaning that investors will always be allowed to sell what they have bought before. A summary of these general rules and order flows are given below in Table 1 and Exhibit 1 respectively.

Meaning behind the connection Although it is clear that the Shanghai‐Hong Kong Connect can boost the market — and it is true given the short term performance of Chinese stock market — the expectation from the central government is far more than that. As one steady step towards a more liberalised financial market, it is an inevitable sign of progress in financial reformation, and part of a bigger structural transition in Chinese economic development. Combining the proposition of the “One belt, one road” strategy, regarded as the Chinese counterpart of the Marshall Plan, it is not difficult for us to see the determination of this big country to implement its globalisation strategy. Therefore, the impact of the Shanghai‐Hong Kong Connect to the Chinese stock

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FUNDAMENTALS

Table 1. General Rules in Shanghai‐Hong Kong Stock Connect1 market is a long‐term one, regardless of the recent strong short‐term surge in the stock market.

Exhibit 1. Illustration of order flow1 1 2

The falls of A share — A historical review Fortunately and unfortunately, we need not consider the global market trend to analyze the Chinese stock market. If we take a look at the comparisons between China and some other countries, we find that there is little relationship between them. China is not closely tied to the global markets, and its financial system is still partially controlled by the central government2. Therefore, the notion of Chinese shares not following the global market does not seem that hard to believe. What is strange though is that the ups and downs of A shares are also uncorrelated to the domestic economic trends. Despite the rapid growth, China’s stock market has been bearish for a long time (see Exhibit 2). Although the stock market once peaked in 2007, it rapidly went down in the following year and reached a trough under 2000 points — investor confidence was greatly damaged ever since. Hence, it is generally believed that the Chinese stock market is not a good indicator of the economy it represents. Why is this so?

The mechanism is the biggest factor to blame:

Information Book for Investors, http://www.hkex.com.hk Etnet. (2011) Mechanism causes the problematic A share market. Available from: http://news.etnet.com.cn/financial‐EtnetcolB132/7547.htm

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FUNDAMENTALS

Exhibit 2. Historical trends in Shanghai Stock Exchange Composite Index3 Regardless of the peak in 2007, there are inherent flaws in China’s stock markets. Right from the establishment of the Shanghai Stock Exchange (SSE) in 1990, the purpose of opening up an exchange is very clear: the government wanted to provide a platform for state‐owned enterprises to attain financing through investors. Back then, all the state‐own enterprises were heavily funded by central government.

With a very high deficit, however, the government could no longer sustain such a big expense, and decided to let the market bail these companies out4.

Therefore, those enterprises that went on IPO were not necessarily good enterprises—they just needed money. This also explains why most of the listed companies cannot make dividend payments. From this, we deduce that the main function of the SSE is to finance enterprises instead of providing returns to investors5. For decades, this has been the main theme played out in the Chinese stock market. As a result, widespread pessimistic investor sentiments developed and are likely to remain in the long term.

With such investor consensus, a second problem occurs: the Chinese stock market became driven by speculative forces. Contributing to more than 80% of the total trading volume, Chinese individual investors are playing much more important roles than institutional ones6. Meanwhile, the average stock holding period of individual investors is 30 days compared to institutional investors’ 190 days. Therefore, we can well believe that Chinese stock market is full of speculation. The prevalence of “guessing games” causes some anomalies in the market. First, there tends to be an overprice of the ST stocks (high risk stocks from bankrupting companies). This is due to the misuse of these companies as the “shells”7 for those unlisted

companies who want to get listed. By acquiring those ST stocks, the unlisted companies are actually listed without going through the complex IPO procedures.

Second, the phenomenon of IPO underpricing8 is glaringly obvious in China. Studies show that while developed countries may experience a 15% IPO underpricing, the figure can reach 70% among developing countries. For China, the figure even hikes up to 144%. The lack of long‐term confidence and the speculative atmosphere have formed a vicious circle that will be difficult to resolve.

From the analysis above, it can be concluded that the immature regulations of the emerging stock markets of China have caused its downfall. Can the Shanghai‐Hong Kong Stock Connect avoid these same problems?

The structural opportunities for A share Although there are potential benefits of importing foreign funds and restoring A share pricing discount, it is the possibility of improving regulations and investor structures that is most promising. As mentioned above, the problem of speculation essentially lies in the mechanism of A share market, and are further exacerbated by the investor structures. The import of foreign investors through “Connect” can at least have two positive impacts to the current market.

Firstly, more institutional investors — making up the majority of foreign investors — will join the market and take the lead to “correct” market sentiments.

What then, is “incorrect” market sentiment? According to Cass Business School Professor Maik Schmeling, individual investors sentiment is the representative of “incorrect” market sentiment. Their sentiment

Source: Yahoo Finance For interested readers, please refer to Wu Xiaobo’s “The Historic 30 Years” 5 Zhou, X. (2013) The problem of A shares: more financing, less return. Available from: http://stock.stockstar.com/SS2013051200000097.shtml 6 Hexun. (2014) Why A shares are numb to positive news. Available from: http://stock.hexun.com/2014‐05‐15/164802072.html 7 A shell corporation is a company which serves as a vehicle for business transactions without having any significant assets or operations itself.

8 IPO underpricing is the increase in price from the initial offering to the first‐day closing one.

3 4

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FUNDAMENTALS misjudges long term trend, neglects mean‐reversion9 phenomenon, and tends to predict a prolonged trend continuation that is usually wrong10. This is also compatible to Fischer Black’s definition of “noise traders”11. Combining these opinions with the figures listed previously, we can draw the conclusion that the influx of institutional investors can be treated as the import of value investing instead of current speculation. Secondly, more foreign investors would mean an increase in types of investors. Data from the SSE shows that pension funds, insurance and QFII funds have only taken up less than 10% of the total institutional investors currently. The figure in the US is 45%. These institutional investors are generally perceived as the “smart money”, and their existence can guarantee more diversified investment styles which indicate a more mature market.

Another aspect that requires our attention would be corporate governance. As pointed out earlier, IPOs in China have been problematic since its inception.

Fortunately, institutional investors prefer to find out the value of the companies and base their investments on dividends. With more active stockholders, listed companies will give out more transparent disclosures, care more about stockholders’ wellbeing, and form more stringent internal regulations. A better performance of listed companies and a switch of investor expectations would thus construct a much

healthier scenario that strategically restores the inherent flaws of A share market.

A bright future with challenges All in all, the Shanghai‐Hong Kong Stock Connect can be considered a large stimulus to the stock market as well as China’s economy. At the point of writing, the Shanghai Stock Exchange Index has already climbed up 500 points to 2600 since the announcement of the Connect — indicative of market recovery. In addition, with a large increase in trading volume, the market is well believed to receive more foreign funding, and China A shares will be added to the global indexes in a matter of time. However, similar to other innovative tools, the current version of the Shanghai‐Hong Kong Stock Connect is not the ultimate solution. A lack of support of intraday trading, quota restraints, and complicated taxation systems are all potential issues to tackle in the future. With all these considerations, the author believes that although there is a strong boost in the A share market recently, it is caused by short‐term confidence and might be reversed in the near future. In order to further lever up China’s stock market, a modified version of the Connect is required.

With that said, the Shanghai‐Hong Kong Stock Connect is a great milestone of China’s financial reformation in itself, and will continue to bring China’s RMB further to the international stage.

Mean reversion is the assumption that a stock’s price will tend to move to the average price over time.

Schmeling, M. (2007) Institutional and individual sentiment: Smart money and noise trader risk? International Journal of Forecasting. 23(1). p.

127‐145.

11 Black, F. (1985) Noise. Journal of Finance. 41(3). p. 529‐543.

9

10

www.gic.com.sg/careers

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INSIDE ANALYSIS

BRUNEI:

EXPLORING NEW AVENUES

An Oxford Business Group Special Report With major investments in a new refinery, downstream prospects are multiplying The country has long had big ambitions for the downstream segment of its energy sector, and 2014 was the year when they finally began to take shape. The $10bn oil processing and petrochemicals complex planned by China’s Zhejiang Hengyi in Brunei Darussalam passed a crucial milestone in February 2014 when Hengyi and the Bruneian government formed a joint venture, Hengyi Industries. The deal gave Hengyi a 70% stake and the government 30%, for which it paid BN$300m ($235.4m) through the Strategic Development Capital Fund, a sovereign wealth fund.

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INSIDE ANALYSIS New Priorities The Hengyi project is the second major downstream investment in Brunei Darussalam after a $600m methanol plant that opened in 2010. The huge project will go a long way towards meeting the government’s ambitious targets for the downstream segment of BN$21.05bn ($16.5bn) of output and BN$5bn ($3.92bn) of value added annually from the energy sector’s downstream segment by 2035, as set out in the “Energy White Paper”, a policy document published in 2014 by the Energy Department at the Prime Minister’s Office (EDPMO). To secure the Hengyi investment, the government also leased a 260-ha greenfield site for the project on Brunei Bay’s largest island, Pulau Muara Besar (PMB), and committed to building a bridge to the island and a power plant. Hengyi began preparing the site in 2013 with dredging and reclamation to reshape the site’s shoreline, as well as land clearing and backfielding to raise the level of the ground and protect the site from flooding.

The $4.3bn first phase of the project will include an oil refinery producing gasoline, kerosene, diesel and jet fuel, with a capacity of 175,000 barrels per day (bpd). It will also include an aromatics cracker complex consisting of a naphtha cracker, a paraxylene plant and a benzene plant. A desalination plant will provide water. Paraxylene and benzene are crucial feedstocks for the manufacture of polyesters, of which Hengyi is one of the world’s largest producers. Michelle Chong Ming Hui, a planning specialist at Hengyi, said, “There was an alignment of interests between what our company wanted and what the Bruneian government wanted. We wanted to back integration in order to be self-sufficient, especially in paraxylene feedstock. Brunei Darussalam wanted to diversify into downstream industries. There were great synergies for both parties.”

Moving Forward The country’s existing refinery, owned by the Sultanate’s largest producer Brunei Shell Petroleum (BSP), produces about 10,000 bpd, while the Sultanate’s total demand for oil-based fuels is about 15,000 bpd, or less than 10% of the Hengyi refinery’s planned output. Brunei Shell Marketing, the sole distributor of oilbased fuels in the country, plans to also being buying fuel from Hengyi.

The country will supply only 30% of the project’s crude oil, with 70% being imported, probably from the Gulf. In essence, the Sultanate is leveraging its location and its ability to be an anchor oil supplier to attract what will mainly be a processor of imported oil into petrochemicals feedstocks for the Chinese and other Asian markets. By doing so Brunei Darussalam is significantly diversifying its economy away from re-

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liance on its own oil and gas output, a long-held goal.

Chong stressed the advantages of the country’s location, adjacent to the main oil shipping route between the Middle East and China, which runs through the Malacca Strait past Singapore and then turns northeast across the part of the South China Sea that lies between Borneo and Vietnam. “Brunei Darussalam is in a very strategic location,” she said. “We can also export from here to Labuan and the Philippines, and there are other markets close by.”

Support Infrastructure Hengyi and other Chinese producers dominate global polyester production, but they have struggled to remain profitable as rising prices for paraxylene and other feedstocks have squeezed their margins. Despite that, Chinese companies have had difficulty getting permission to build refineries in China, according to Chong, due to problems with pollution associated with older, state-owned refineries. She said Hengyi’s Bruneian project plans to use cleaner and more efficient modern technology. Honeywell subsidiary UOP announced in 2013 that its aromatics technology had been selected for the Hengyi project. Construction of the plant will not begin until the government finalises its plans for the bridge and power plant, which are being handled by the Brunei Economic Development Board (BEDB) and Berakas Power Management Company (BPMC), respectively.

The BEDB is preparing a tender for the PMB Bridge, which will stretch 2.7 km to connect the island to the mainland near Muara, Brunei Darussalam’s main port. A design consultancy contract was awarded in 2012 to a consortium led by South Korea’s Pyunghwa Engineering Consultants. A tender for construction of the bridge was held in April 2014, however, as of August 2014 it had yet to be awarded.

Major Investment Besides selling oil products to Brunei Darussalam and producing petrochemicals for its own use, the project also anticipates exporting oil products to the surrounding region. The refinery will produce gasoline to the Euro IV standard, the highest standard currently in use in South-east Asia. The introduction of Euro IV gasoline will significantly improve vehicle emissions compared to the lower-standard fuels produced by BSP’s older refinery.

such as those derived from methanol.

Akira Ishiwada, the CEO of the Brunei Methanol Company, told OBG, “Looking to the future, the continued development of other downstream derivatives in Brunei Darussalam would positively contribute to the nation’s aim of downstream diversification.”

The paper said the government would study the possibility of investment in midstream aluminium production – making shaped products from raw aluminium – as a lucrative way to utilise more energy resources.

The second phase, expected to begin around 2019, will expand the refinery to produce olefins, add a monoethylene glycol plant and a second paraxylene plant. Hengyi has said the plant’s annual turnover is estimated to be about $10bn. Of the $4.3bn cost of the project’s first phase, $2.8bn is slated to come from Chinese bank loans. The Chinese government is thought to be strongly supporting the project, largely out of an interest in building up its relationship with the Bruneian government. The Sultanate is seen as maintaining balanced relations with both the US and China in a region where many of its neighbours are strong US allies and have conflicts with China over the South China Sea and its islands and sea floor.

New Opportunities Meanwhile, the government remains eager to secure additional downstream investments. Another project it is still hoping to complete is a plan to produce nitrogenous fertilisers from natural gas. The government was also looking into the construction of a complex that would produce ammonia and urea, though no further announcements have been made. Mitsubishi is also looking into a new method of producing and shipping hydrogen fuel, a nascent alternative automotive fuel produced from natural gas. Hydrogen-fuelled cars emit only steam and can drive further and refill faster than electric cars, but so far are more expensive. The project would bond hydrogen with toluene to make it liquid and thus allow it to be easily shipped to Japan, which is furthest ahead in producing hydrogen-fuelled cars and filling stations thanks to a national hydrogen-car subsidy programme.

The EDPMO’s “Energy White Paper” also floated several other ideas for downstream investment, for which the government is actively seeking investors.

These included production of other petrochemicals,

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CAREERS

INTERNSHIP AT MACHLIN ORACLE

by Ruofan Ni The concept of a family office is probably well known in the Western world, but it is rarely known outside of it. A family office is a company which helps wealthy people to manage their assets and daily life. The function of a family office is quite broad, ranging from travelling arrangements, children’s education to property management. The main function of a family office undoubtedly is to manage their clients’ capital.

Fund managers, registered under a bank, are authorized to invest that money based on clients’ requirement.

There are two types of family office – single family office and multi-family office. The greatest advantage of a single-family office is that the company only serves a specific family, and the company puts all its effort and attention to that family. This is important especially pertaining to legal and private issues. Wealthy families have – and need only interact with – a central source that can better cater to the families’ needs and wants. Multi-family offices, on the other hand, serve the interests of several families at the same time.

Cost efficiencies can be achieved by spreading expenses over a large asset base. Although multi-family offices still apply tailored solutions to their clients’ problems, their focus and attention is also spread over various clients, which can be a disadvantage for such a business.

the analyst | 38

Having worked in a family office, I would like to shed some insight on the work involved in such a business.

When I worked as an assistant to a managing director this summer, I got a taste of different work in a family office. The company I worked for was quite small: two asset managers, two traders, a business developer, a researcher and three other interns. My company, Machlin Oracle, a multi-family office, was trying to build up a business relationship with an investment bank in China, and the clients there happened to be interested in wine. Fortunately, our company had an alternative investment portfolio in French wine. There were more than 400 different kinds of wine available for them to select from, and so my first task was to translate those French labels into Chinese.

However, my main job in this family office was to focus on equity research. I worked for an asset manager and he taught me how to look at their annual report.

He highlighted which parts of the report I needed to focus on, and used highlighters to underline key figures. Just within two weeks, I analysed three companies listed on the Hong Kong Stock Exchange, and made an oral report back to my manager. My report looked into each business segment of these companies, and I also produced a cost and benefit analysis.

A number in the context does not make any sense unless you can compare it with a market benchmark or similar companies. It was my first time reading financial statements, and it was a challenge to read off figures from it and built up a simple model on Excel

CAREERS to carry out comparable analysis across industry. Besides that, I also did daily summary on Chinese markets by summarizing information on Financial Times and BBC news, to provide my views on Chinese industry trend and companies’ scandal for my manager. I was also in the marketing team to assist social marketing- Weibo, a twitter-liked Chinese app, in order to introduce the concept of family office, which is an unfamiliar term in Chinese culture.

I shadowed a managing director and attended several meetings with the clients. On the first day, I met a lawyer. On interesting thing I learnt from their conversation was about how one builds up a close relationship with his clients. I was shocked upon observing their conversation - they did not talk about any business whatsoever for the first 45 minutes. The conversation mainly involved questions like ‘how did you spend your summer’, ‘where did you go’, and ‘how is your family’. In fact, half an hour was spent talking about their pets! There is no need to mention the details of their conversation, but in the last 10 minutes, they got serious and discussed how they could work together. My manager said she wanted to introduce one of her Chinese clients to him to have a discussion about legal issues this client involved.

The lawyer was glad to help her clients and he promised her to bring more of his own clients to her in the near future. The conversation was simple but a solid relationship was built up simply through their conversation regarding their personal lives.

The next meeting I attended with my managing director was with an accountant and his main role was to help his clients legally reduce their tax exposure.

Regulation in the UK was rapidly changing and he needed to help his clients to adapt to new tax laws.

Establishing a trust fund was one such option to reduce tax. My manager was interested in this because she wanted to help her clients to get a better value after they immigrated to the UK. I thought it could be difficult for my manager to build up a close relationship with this accountant since they have barely met.

Instead, she focused on asking him how he met her friend. She found one thing and probably the most important thing in common – a mutual friend. She also noticed that she had attended a social event which he was planning to go, so she shared more about her experience in that event and what she found particularly interesting about it. It was possible to pick up some social skills just by seeing how my manager established business relationships with others.

After the financial crisis, people started to doubt about the sustainability of family office. One of the greatest challenges family offices face is the question of whether active fund management could beat the market and bring higher monetary returns com-

pared to index funds. The index fund, which was first claimed by John Bogle, had changed people’s perception of investment. The main strategy is to rely on the power of compounding, low income tax, management fees and turnover costs, in order to offer substantial returns and beat most active fund managers.

However, this is not the only challenge family offices face.

The regulatory environment has changed significantly over the recent years. Family offices which had previously been exempted from the Securities and Exchange Commission reporting standards no longer qualified for this, and several bills had been introduced to eliminate such loose reporting standards.

Intense SEC oversight could jeopardize family privacy and confidentiality and, as a result, could drive up the operating cost of family office.

Meeting clients’ new requirements could be challenging for family offices. Many family offices have received additional requirements from their clients.

Among those new requests, education for younger family members has become more significant over years. The main function of the family office is to take care of family businesses, helping it grow from generation to generation. Accordingly, education and training of younger family members and helping them to get involved in the business have become more important than ever.

After the financial crisis, single family offices were particularly vulnerable affected by a decline in their only source of assets – that from the single family.

But there are a few options for existing for struggling single family offices. The first option could be transforming into a multi-family office since managing a greater amount of capital can bring down operating costs. It is favorable for the struggling companies as expertise in investment and family services can be best used. Despite all the benefits, only a few single family offices have successfully transformed. Different culture and ways of running business seemed to be difficult for them to merge. If the option of making the shift into a multi-family office does not sound viable, outsourcing to multi-family offices is another alternative. In this way, professional services can be pooled by working closely with other family offices.

Lastly, another option is to close this company but this can be emotionally difficult due to the strong relationship with the client.

No one knows the future of the family office though it will always be needed when it comes to helping family businesses grow. I strongly believe that there is a bright future found in the emerging markets, as we see the rise of an ever-increasing number of rich families there.

the analyst | 39

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the analyst | 40